Bounce: The USD And Stock Prices

Includes: SPY, UDN, UUP
by: Keith Summers, CFA

Did you see what happened to the dollar last month?

Not many people are asking that question, and yet that story, rather than QE Infinity, Netanyahu's "red lines" statement about Iran or the much-appreciated rally in equity prices was more significant to investors than most commentators seem to have noticed.

The trade-weighted value of the US Dollar fell precipitously in September and has fallen 5% from the end of May until it bounced off of EURUSD of $1.32 on Sept. 17.

There are a couple of different ways to interpret this.

First, one could conclude that the further loosening of US monetary policy announced by the Fed in September sparked a 'sell' on the USD in anticipation of higher inflation expectations raised by expansionary monetary policy.

Or, one could conclude that the USD, as the safe haven during 'risk-off' periods in the market when investors are running for cover, experienced a normal decline in demand as investors went into 'risk-on' mode and preferred riskier assets. Consider that for the first time in over two years, US equities were in the bottom quartile for performance amongst other countries.

The 'risk-on' story is strengthened by noting that both reported earnings and forecasted earnings increased slightly for global stocks (although stayed steady for US stocks).

Earnings valuations (P/E ratios) also grew slightly for both US and global stocks: clearly the signs of a risk-on state of investor confidence.

But the question remains, after enduring such volatility throughout 2011 due to political factors in Europe and Washington (and neither of those problems has been solved), what would trigger another risk-off trade and flight from equities?

One of the maxims in this business is that stocks climb a 'wall or worry', and that is what they seem to be doing right now. European budget crises, the fiscal cliff and heightened tensions in the Middle East are all problems that remain unsolved. But the sense we're getting from talking to people in DC is that the fiscal cliff will be somewhat 'kicked down the road' with neither the full effect of tax increases or sequestrations coming into effect right away.

European government finances are a problem that won't be solved anytime soon, but probably won't trigger Armageddon next week either. The attention is on Spain right now, but Italy and Portugal are waiting in the wings. Continued volatility in the Eurozone is to be expected, and this continues to impair global growth but hasn't killed it. Corporate profits, even in Europe, are forecast to grow over the next 12 months and showed improvement in September too.

The dollar's decline, of course, helps the US manufacturing sector which, although a smaller part of the US economy than it used to be, is still critical to the long-term success of the US economy. A more robust US manufacturing sector was evident when the Purchasing Manager Index for manufacturing for September reported more firms had seen their order books grow than shrink (ending a two-month losing streak). The equity markets take this as a bullish sign and rally and this in turn, feeds into increased consumer confidence which propels the economy even more.

Reported earnings for global stocks are still more than 10% below their 2008 highs, while stock prices are almost 25% below their 2008 highs.

Stocks still have lots of room to move up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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